Emerging VCs are facing rising pressure to generate returns for their investors after several years of sub-par performance. As a result, demand has concentrated around certain deal types, specifically AI and pre-IPO companies. However, fundraising challenges have made it difficult for emerging managers to gather the substantial capital required for these opportunities.

Late-stage companies, particularly AI startups like OpenAI and Anthropic, have attracted significant investment, but gaining direct cap table access to these companies is very difficult due to their high valuations and popularity. To overcome this, investors are turning to “pass-through” SPVs. 

What is a Pass-Through SPV?

The term “pass-through SPV” typically refers to an SPV that is used by VCs to pool funds and invest in another pass-through entity (i.e. SPV), which has a direct allocation in a target company. These structures involve multiple pass-through entities that form the layers. Each SPV contributes funds up the chain until reaching the final investment.

Since these SPVs allow multiple investors to pool their resources, this approach makes it possible for investors to join high-value deals that would otherwise be out of reach.

Pass-through SPVs offer access to valuable investments and help emerging managers build stronger relationships with their investors by providing stakes in top companies. However, while this strategy opens up new opportunities, it also brings significant operational challenges, especially around transparency and tax reporting. 

Why this is Happening

Access

Emerging managers struggle to meet the high minimum check sizes required for these coveted deals. By sourcing allocations through larger firms' SPVs, which might have $10-50M already secured, they can participate without needing to secure massive capital commitments or get a direct cap table allocation.

Investor Demand for Later Stage/More Liquid Deals

Investors are pushing for later-stage investments with higher liquidity potential due to recent record-low returns in venture capital.

Fund Size & Portfolio Construction

Pass-through SPVs allow emerging managers to participate in larger funding rounds without coming up against certain portfolio construction limitations. Standard operating agreements often limit the amount of capital from a fund that can be invested in a single portfolio company. However, SPVs allow managers to raise substantial capital through a sidecar vehicle, avoiding limitations that exist for their flagship fund. 

Prominent Pass-Through SPV Deals

Recently, investors have used pass-through SPVs to secure stakes in high-demand AI startups like OpenAI and Anthropic. These structures pool funds from multiple parties, allowing smaller investors to participate in substantial deals they would otherwise miss. This trend has gained momentum as demand for AI startup shares has surged.

Thrive Capital's OpenAI SPV

Earlier this year, Thrive Capital led a significant purchase of existing OpenAI shares, estimated to be worth hundreds of millions of dollars. Thrive also created a smaller SPV, under $10 million, to give its investors additional exposure to the ChatGPT developer. Similarly, Soul Ventures and SparkLabs Global Ventures used SPVs to buy shares in OpenAI during a sale that valued the company at $86 billion. These SPVs provide a flexible way to increase holdings in coveted AI startups.

Menlo Ventures' Anthropic SPV

Menlo Ventures employed a pass-through SPV to take a prominent position in Anthropic. Menlo raised $750 million through an SPV, allowing it to invest heavily in the AI startup, which saw its valuation soar to $18.4 billion. This strategic move enabled Menlo to increase its stake without overextending its main venture fund. The SPV also included contributions from insiders and other key partners, maximizing the investment's impact.

Emerging Manager Perspective

Sydecar spoke directly with several emerging managers who identified the potential benefits and challenges when considering pass-through SPVs. 

One major concern is the “look-through” rules. If an SPV invests in another SPV that qualifies for an exemption pursuant to Section 3(c)(1) of the Investment Company Act of 1940, the manager of the underlying SPV might have to count all the SPV’s investors towards the 100/250 investor limit. 

For example, taking a $100K check that counts as 20 investors is less attractive than a $100K check that counts as one. This issue can manifest in two main ways:

1. Statutory Issues: According to 15 U.S. Code § 80a–3(c)(1)(A), when counting the beneficial owners of a 3(c)(1) fund, if the SPV owns 10% or more of the underlying fund, all entity investors in the SPV will count towards the 3(c)(1) limit. This is a clear rule but can be avoided by ensuring no entity investor in a 3(c)(1) fund owns more than 10% of the underlying fund.

2. Regulatory Issues: The SEC has stated through a series of no-action letters that if an SPV invests more than 40% of its assets into another 3(c)(1) or 3(c)(7) fund, there is a presumption that the SPV was formed for the purpose of investing in the underlying fund, and all the SPV investors would count towards the underlying fund's investor limit. This gray area requires careful consideration, although some precedents, like the Cornish & Carey letter, suggest that intent plays a role in the SEC’s determination. Specifically, funds should not be structured to circumvent regulatory provisions. 

Additionally, an SPV that invests in another pass-through entity, rather than directly into a target company, is generally required to have a higher investor accreditation status than the standard accredited investor (i.e. qualified client or qualified purchaser). 

Fiduciary duties also pose a challenge: 

From a practical standpoint, managers must also consider the logistical complexities. Different SPVs might have varying advisors, structures, and requirements, complicating integration and management.

In an interview, one manager explained their cautious approach to pass-through SPVs: 

Another manager noted that while they have not yet organized an SPV that accepted investment from another SPV, they have had discussions about potential structures. These include co-GP relationships where two GPs manage an SPV together, optimizing logistics and sharing economics. 

Overall, while pass-through SPVs offer access to high-demand deals, emerging managers must navigate regulatory, fiduciary, and logistical challenges. Sydecar's platform helps mitigate some of these issues by providing compliance and administrative support, making the process more efficient and transparent. 

Investor Perspective

Investors have mixed views on pass-through SPVs due to the potential for stacked fees. When fees from multiple layers of SPVs are combined, the overall cost eats into the investment amount, reducing the investor's exposure to the company and making these deals less attractive. Some managers address this by reducing fees or waiving them altogether, focusing instead on the value of access to high-demand opportunities. This strategy helps strengthen relationships with LPs, who may be more willing to invest in other vehicles where fees are charged.

SPVs often include preferential terms for a VC’s own backers. For instance, in the recent Anthropic round, fund LPs were expected to benefit from reduced or waived fees, making the investment more appealing to existing LPs. 

Overall, while the prospect of stacked fees in pass-through SPVs can be a deterrent, transparent communication and strategic fee structures can enhance the attractiveness of these deals for LPs. By focusing on the value of access and maintaining strong LP relationships, managers can alleviate investor concerns and encourage them to continue investing.

Complexity of these Deals

Operational Complexities

Investing in pass-through SPVs can introduce operational challenges. Managers must ensure they raise enough money to cover fees for both the investing SPV and the underlying entity, which might require holding back some funds if not all fees are paid upfront. Transparency is crucial; managers must inform investors that their SPV is investing in another SPV, not directly in the target company. If the underlying SPV doesn't secure an investment in the company, the investors' funds might not be used as intended. This could result in returning the capital to investors, potentially reduced by fees, even though the deal didn't go through. Additionally, even if the investment doesn’t proceed, investors will receive a distribution, which may have tax consequences, and they will be issued a Schedule K-1 for their tax reporting.

Tax Complexities

Tax reporting for pass-through SPVs can be intricate, requiring waiting for underlying K-1s which can trigger filing extensions. As mentioned earlier, SPVs are typically formed as pass-through entities. This means that all income and deduction items pass through to each investor, retaining their tax characteristics. This information is communicated to each investor through a Schedule K-1. Each entity must first receive a K-1 from the underlying ‘layer’ (SPV) before it can file its tax return. The more layers there are, the longer the chain of K-1s. Depending on an SPV’s position within the chain, investors may need to wait significantly longer for their K-1s, requiring investors to extend the filing date of their own tax returns.

Importance of a Reliable Admin Partner

Given the complexities of managing pass-through SPVs, having a dependable admin partner like Sydecar is paramount. Sydecar ensures transparency, accurate tax reporting, and compliance, enabling emerging managers to navigate these pass-through investments effectively. Check out our Pass-Through SPVs page for more information about how we support these investments:

Sources:

1. VCs are selling shares of hot AI companies like Anthropic and xAI to small investors in a wild SPV market

2. Inside AI Unicorn Anthropic’s Unusual $750 Million Fundraise

3. How Investors are Using SPVs to Buy Stakes in OpenAI and Anthropic

4. LinkedIn – Chris Harvey

5. Private Fund Adviser Rules